February 2012

As mentioned on Brock and Dave’s Blog and a recent article by Bloomberg, the conflict minerals disclosure required by the Dodd-Frank Act appears to be close to final. These proposed rules are highly controversial because of the estimated high costs for public companies to comply with the new rules compared to the small perceived benefit to investors. In fact, we have previously blogged regarding the likelihood that the SEC has grossly underestimated the compliance costs.

Under the proposed conflict minerals rules, companies must disclose whether certain minerals used in production chains originate from the Democratic Republic of the Congo or its neighboring countries. Minerals sourced from these areas of central Africa often fund militia and other military groups’ operations which have exacerbated internal conflicts and human rights violations. Congress believes that by requiring these disclosures public companies may be encouraged to seek alternative sources, materials, or suppliers to project a more socially responsible image to consumers.

In a letter to the SEC, Senator Leahy and other members of Congress have taken issue with the proposed final rules apparently circulating around the Capitol. In the letter, the Senator and his colleagues have informed the SEC that they believe the proposed final rules contravenes Congress’s legislative intent by allowing the conflict mineral reports to be “furnished” rather than “filed.” The difference, of course, is not just semantics. Items “filed” in periodic reports are subjected to liability under the Securities Act of 1933, including Section 11 and Section 12(a)(2), because the information is incorporated by reference into Securities Act registration statements. Items “furnished” are subject only to liability under the Securities Exchange Act of 1934, primarily Rule 10b-5. Because Section 11 liability presents essentially “strict liability” for issuers, it would be much easier for a plaintiff to win a judgment against an issuer for faulty conflict minerals disclosure if the disclosure is “filed” rather than “furnished.”

On February 13, 2012, the Securities and Exchange Commission issued a No-Action Letter to the Fenwick & West LLP law firm. This No-Action Letter is good news for private companies that are approaching the statutory 500 shareholder limit (which would generally require them to register as public reporting companies under Section 12(g) of the Securities Exchange Act of 1934). Exceeding this limit can be very painful for a company, as it may be forced to register its class of shares under the Securities Exchange Act of 1934, which would require significant disclosures of information (the same as if it had undertaken an initial public offering) without realizing any of the benefits of public company status. The No-Action Letter will allow private companies to issue certain equity-based compensation to employees, directors and some consultants without triggering the reporting requirements of the 500 shareholder limit. Fenwick’s original request for the No Action Letter (which describes the background of this situation) can be found here.

Fenwick is the law firm that represents Facebook in its current initial public offering. Fenwick had previously sought and obtained similar relief specifically for Facebook in 2008. In this No-Action Letter, however, Fenwick obtained a much broader exemption from the SEC on this issue. Since the No-Action Letter was issued to the law firm rather than to a single company, the relief from these public reporting requirements should be very broad and should be applicable to any company whose situation is close enough to that described by Fenwick in its request for the No-Action Letter.

The situation that Fenwick used here involved “restricted stock units” (“RSUs”). RSU’s as described by Fenwick in the No Action Letter are equity compensation vehicles that generally entitle the holder to receive shares of a company’s common stock if certain future conditions are met before the RSUs expire. These RSUs are widely used by some companies, but there was a question regarding whether the issuance of an RSU caused the recipient to become a shareholder of the company, thus increasing the number of total shareholders and potentially causing the company to exceed the 500 shareholder limit. Continue Reading SEC’s No-Action Letter is good news for pre-IPO companies

When someone refers to a company as being “publicly traded” we normally understand that to mean that it has sold shares to the public through an initial public offering (or “IPO”) and is listed on a national securities exchange (like the NYSE or Nasdaq) and makes periodic filings with the SEC. However, some smaller companies that are not listed on a national exchange and that have never filed any documents with the SEC are coming to find out that they may in fact be “publicly traded” and may not even realize it. Moreover, being classified as “publicly traded,” under certain circumstances, can impose requirements on the company to provide notice for certain corporate events and pay associated fees.

Rule 10b-17 and FINRA Rule 6490

Section 10(b) of the 1934 Securities and Exchange Act (the “Exchange Act”) is one of the anti-fraud provisions of the Exchange Act and imposes liability on persons engaged in the use of “manipulative or deceptive devices or contrivances” in connection with the purchase or sale of a security. Pursuant to its rule making authority, the SEC has enacted a number of rules (the most well-known of which is Rule 10b-5) which regulate these manipulative and deceptive devices and contrivances in order to protect investors.

Less well-known among these rules is Rule 10b-17 which relates to untimely announcements of record dates. Specifically, Rule 10b-17 states that failure by an issuer of a class of securities publicly traded to give 10-days’ prior notice to FINRA of the establishment of record dates relating to dividends, distributions, stock splits, or rights or other subscription offerings, constitutes a “manipulative or deceptive device or contrivance” for Section 10(b) purposes.

FINRA Rule 6490 (effective as of September 27, 2010) codified the Rule 10b-17 notification requirements and requires issuers subject to the rule to pay the applicable fees in connection with their submission of the required notice. Most notably, notifications which are late can trigger a late fee of up to $5,000.

As reported in the Wall Street Journal, Facebook, Inc. filed a registration statement with the SEC late Wednesday to register to go public. This continues the recent trend of established technology companies going public since the beginning of last year. Whether the stock price ultimately supports its expected lofty valuation remains to be seen.

While the IPO has been long-expected, it is important to remember the reason why Facebook decided to go public: it was required. Section 12(g) of the Securities Exchange Act of 1934 requires companies that have at least $10,000,000 in assets and at least 500 shareholders as of the end of its fiscal year to register with the SEC. This shareholder limit has not been adjusted since its adoption in 1964, and causes companies that need to raise capital to face two equally unappealing choices: limit the number of investors to ensure the 500 limit is not breached or register with the SEC regardless of whether being a public company is in the company’s best interests once the limit is met. While a recent proposed bill in the House has attempted to lessen the burden on private companies looking to raise capital by increasing the shareholder limit from 500 to 1000, to date no legislation has been enacted into law. The SEC is also reviewing the shareholder limit.

Until Congress or the SEC acts, private companies should consider taking a few safeguards to avoid the requirement to register with the SEC. First, adopt a shareholders’ agreement that restricts the transferability of the shares. The transfer restriction will prevent shareholders from subsequently transferring their shares to multiple new shareholders which could cause the company to exceed the limit. Second, issue stock options to employees rather than shares of stock. Stock options are considered a separate class of equity security, and since 2007, the SEC has exempted companies from having to register under Section 12(g) because there were more than 500 option holders. Third, private companies can adopt an insider trading policy that prohibits any employee from reselling their shares. Facebook adopted such a policy, which effectively eliminated the secondary distribution of its shares. Fourth, companies can implement high transfer fees to restrict the distribution of its shares similar to the fees Continue Reading Missed in Facebook IPO frenzy: they had to go public. Here are 6 ways private companies can remain private

About this Blog

The Securities Edge is published by Gunster’s Securities and Corporate Governance Practice. Our blog focuses on securities law topics of interest to executives of middle market businesses. We try to focus on the most important issues of the day and distill the complex and convoluted into easy to understand blog posts so company executives can get up to speed and move on to what’s really important: running their business.